Distribution is the original token problem
In January 2014, a startup called Counterparty launched one of the first public ICOs.
Counterparty offered its new XCP token in exchange for Bitcoin. The catch? People had to “burn” or destroy their Bitcoin to receive XCP.
Say what?? 😲
Counterparty’s goal was not to raise money. Instead, their goal was to distribute their tokens to lots of people in a fair and transparent manner.
The Counterparty developers believed that people wouldn’t be OK with trusting developers with tons of money pre-product.
Imagine Satoshi had suddenly appeared out of nowhere with his great idea and a pile of bitcoins for sale at, say, a dollar each. Would he have won the backing of the countless people who have since invested their money, time and resources to build the infrastructure that is making Bitcoin successful? Or would people have instantly suspected some kind of pump-and-dump currency scam and steered well clear?
Ethereum popularizes the ICO as a fundraising tool
Ethereum goes live in 2015, making it super easy for anyone to launch a new token. What happens? An ICO explosion. Developers co-opt ICOs as a way to raise money fast. In 2017, 525 token projects raise $6.5 billion dollars through ICOs. That’s equal to 3 percent of the amount raised through IPOs!
ICOs were so good at raising money that the community didn’t stop to ask, “Are ICOs really the best mechanism for distributing tokens and driving long-term growth”?
Airdrops enter the scene
In 2017 a blockchain startup called OmiseGo launched one of the first token ‘airdrops’, or free token giveaway.
“Not everyone has the time, opportunity, and technical [skills]” to buy tokens in a token sale, they said at the time. So instead of selling tokens for distribution, OmiseGo gave them away. They transferred tokens to 460,000 accounts without the account owners’ permission. The goal was to “create interest in OmiseGO”.
Since then, thousands of token projects have copied OmiseGo’s model. They raise money through a token sale, then use a free token giveaway as a distribution mechanism.
Did it work?
Not really. The majority of people who receive free tokens view them as spam. There are some people who spend hours tracking and signing up for airdrops. But they don’t plan on using the tokens. They just hope to make money if the tokens appreciate in value.
The dream: ICOs and airdrops are a self-executing driver of network effects
ICOs and airdrops were meant to jumpstart long-term growth by distributing tokens to a wide range of people. But they failed because the people receiving the tokens usually don’t use the product and are incentivized to free ride on the network’s growth.
- A blockchain project creates a new token which is used within their product.
- As the project grows, the value of their token rises in value due to the Quantity Theory of Money (MV=PQ).
- The blockchain project gives tokens to early speculators through an ICO or airdrop. These speculators are incentivized to grow the network since their tokens appreciate in value as the network grows.
- This ‘seeds’ network effects. Over time, the actual utility value of the network begins to pick up, which attracts more users to the network, and creates a virtuous cycle.
- As the network grows, the price of the token increases, which rewards the early adopters.
Boom! Tokens solve the bootstrapping problem and drive network effects.
Reality: Distributing tokens via ICOs and airdrops doesn’t build network effects
The ‘tokens bootstrap network effects’ theory breaks down in practice.
Tl;dr: Early token holders are not sufficiently incentivized to use the product nor grow the network.
There’s nothing about someone holding a token that increases usage within a network. Having users that can theoretically pay for a service does not qualify as demand for a product. If it did, then AirBnb could have said, “Hey, look at the 300M Americans who hold USD and can use our product. We have network effects!” Speculative investors might help grow the network by promoting the product to others. But this rarely happens due to a collective action problem. Each investor has an incentive to free ride on the growth of the network.
A network effect happens when the product or service becomes more valuable as more people use it. Usage, not growth in vanity metrics like number of token holders, is what leads to network effects. Speculative investors do not contribute to a network effect when they simply hold a project’s token. In fact, they might have a negative impact on network effect since they are holding a scarce resource that could be held by actual users.
A token sale can increase the value of the network insofar that the project uses the proceeds to build a product that people want to use. But giving tokens to early adopters, through an ICO or airdrop, is not a self-executing driver of network effects.
Fundamentally, fundraising and growth are two different goals that require different mechanisms. Using ICOs to do both sounds amazing in theory, but it breaks down in practice. Airdrops are also a flawed growth mechanism. Recipients are motivated by the promise of free money, with no clear incentives to grow the network, use the product, or increase utility.
But wait! There’s still hope for tokens
Tokens are an extraordinary tool for driving network effects. But they need to be programmed to incentivize usage of the platform, since this is the behavior that actually builds network effects.
As Chris Burniske says, the most successful cryptonetworks will have ongoing incentives for usage baked into the network design.
But designing a perfect cryptonetwork from the beginning is hard — that’s why we need a modular way to add incentives to cryptonetworks ad hoc.
Thanks to Rahul Raina, Larry Braitman, & Trevor Wright. Shoutout to the folks pushing these ideas along: Chris Burniske, Chris Dixon, Kyle Samani, Dan Elitzer, Wilson Lau, Vitalik Buterin, Anu Hariharan, Fred Ehrsam, Warren Weber, Brian Koralewski, William Mougayar, Balaji S. Srinivasan, Brian Armstrong, Nick Tomaino, Fred Wilson, Jeremy Lam, Joey Krug, Olaf Carlson-Wee